Note to Krugman: Greece Proves Keynesian Economics Wrong

Forbes Economics|3/18/2012

Times columnist Paul Krugman’s continuous railing against austerity reached a crescendo with Greece’s default. In his What Greece Means, Krugman vents his outrage:

“What Greek experience actually shows is that while running deficits in good times can get you in trouble… trying to eliminate deficits once you’re already in trouble is a recipe for depression…Greece is the worst case, with unemployment soaring to 20 percent even as public services, including health care, collapse.”

Bankrupt economies, like Greece, need stimulus, not austerity, Krugman declares indignantly. The “austerity-induced depressions” around the European periphery are proof that Keynes was right. Germany’s Angela Merkel, her IMF-austerity allies, and world-wide lenders do not understand that we need a massive stimulus to get Greece out of this mess. They need to step up to the plate if they are good citizens of Europe (or the world).

Krugman does not fess up that Greece’s Keynesian policy of endless borrowing to fund wasteful government spending and feed massive welfare programs is exactly what got Greece in the trouble it is now in. The Greeks cannot pay their bloated public payrolls, out-of-kilter wages, and generous pensions and early retirements unless fools lend them money that will not be repaid. Even the Greeks themselves are not falling for that trick. They are too busy transferring their assets abroad. Merkel and her stingy Germans make for good scapegoats, but it’s not only them. Lenders throughout the world have shut down the lending spigot.

Liberals are gearing up to use Krugman’s Greek fable of “Keynes has won” to justify further trillions of U. S. debt and growing government to ever greater heights, as Times columnist Nicholas Kristof reveals in his In Athens, Austerity’s Ugliness:

After months of refusing to countenance the possibility of Greece leaving the euro, eurozone politicians are slowly beginning to acknowledge there may be no option but to let the country go.

Greece's political parties have failed to form a working coalition following voters' rejection earlier this month of austerity measures insisted upon by the European Union and the International Monetary Fund, so the Greeks will return to the polls in June.

The vote is being seen as a referendum on the euro. Syriza, which came second in the recent election, is promising to freeze payments to creditors and renegotiate the terms of the bailout from the EU and IMF - terms that demand austerity measures to bring down Greece's debts.

Germany has said the loan terms are not negotiable.

But even if the pro-austerity parties win the election, Greece may still be forced to give up the euro.

Why is Greece in trouble?

Greece was living beyond its means even before it joined the euro. After it adopted the single currency, public spending soared.

Public sector wages, for example, rose 50% between 1999 and 2007 - far faster than in other eurozone countries.

And while money flowed out of the government's coffers, its income was hit by widespread tax evasion. So, after years of overspending, its budget deficit - the difference between spending and income - spiralled out of control.

When the global financial downturn hit, therefore, Greece was ill-prepared to cope.

Debt levels reached the point where the country was no longer able to repay its loans, and was forced to ask for help from its European partners and the International Monetary Fund (IMF) in the form of massive loans.

In the short term, however, the conditions attached to these loans have compounded Greece's woes.

What has been done to help Greece?

In short, a lot.

In May 2010, the European Union and IMF provided 110bn euros ($140bn: £88bn) of bailout loans to Greece to help the government pay its creditors.

It soon became apparent that this would not be enough, so a second, 130bn-euro bailout was agreed earlier this year.

As well as these two loans, which are made in stages, the vast majority of Greece's private creditors agreed to write off more than half of the debts owed to them by Athens. They also agreed to replace existing loans with new loans at a lower rate of interest.

However, in return for all these loans, the EU and IMF insisted that Greece embark on a major austerity drive involving drastic spending cuts, tax rises, and labour market and pension reforms.

These have had a devastating effect on Greece's already weak economic recovery - in the first three months of this year, initial official estimates suggest the economy shrank by a frightening 6.2%. Greece has already been in recession for four years.

Without economic growth, Greece cannot boost its own income and so has to rely on aid to pay its loans. Many commentators believe even the combined 240bn euros of loans and the debt write-off will not be enough.

Strictly speaking, a default occurs when a borrower has broken the terms of a loan or other debt, for example if a borrower misses a payment. The term is also loosely used to mean any situation that makes clear that a borrower can no longer repay its debts in full, such as bankruptcy or a debt restructuring.

A default can have a number of important implications. If a borrower is in default on any one debt, then all of its lenders may be able to demand that the borrower immediately repay them. Lenders may also be required to write off their losses on the loans they have made.

BERLIN — With political allies weakened or ousted, Chancellor Angela Merkel’s seat at the head of the European table has become much less comfortable, as a reckoning with Germany’s insistence on lock-step austerity appears to have begun. “The formula is not working, and everyone is now talking about whether austerity is the only solution,” said Jordi Vaquer i Fanés, a political scientist and director of the Barcelona Center for International Affairs in Spain. “Does this mean that Merkel has lost completely? No. But it does mean that the very nature of the debate about the euro-zone crisis is changing.”

A German-inspired austerity regimen agreed to just last month as the long-term solution to Europe’s sovereign debt crisis has come under increasing strain from the growing pressures of slowing economies, gyrating financial markets and a series of electoral setbacks.

Across the Atlantic in Europe, a different type of haircut has been debated. The Greek debt crisis is a catastrophic confluence of events. Internal mismanagement and external economic forces have resulted in a recession the depths of which a modern country has never seen. Private creditors (mainly banks) have grudgingly agreed to take a haircut of up to 78% of their debt, but only after they secured a recapitalization plan and only after an agreement was made to use bailout funds almost exclusively to shore up European banks instead of for assistance for the Greek people (read more about that tragedy here and here).

While the Greek government was used essentially as a pass-through to shore up the European banking system against a sovereign Greek default, Greek citizens watched as their social safety net was set on fire:

Greece, one of three eurozone nations to need an international bailout, has cut spending on just about everything it can — public sector salaries, pensions, education, health care and defense. As a result, unemployment has soared to over 21 percent, fueling social unrest that has sometimes turned deadly. In the last two years, riots have erupted frequently and the country's near-daily strikes and demonstrations have shut down schools, airports, train stations, ferries and harmed medical services.
If you ever wondered what Social Darwinism looks like, that's it.

Keynesian Economics Is A Failure
Keynesian exuberance for the powers of stimulating demand or the 'consumer' has been in vogue since the 1930s. It is sheer nonsense which is taught in every school across the globe. Keynesian economics is little more than intellectual pablum used by those in power or by a technocratic and largely illiterate elite to increase their power; enhance government; print money and otherwise destroy normal economic relationships. Keynes' theory, so believed by professors is in practice a disaster.

Keynes was a left wing wall flower and a member of the deranged Bloomsbury group of inter-World War British pacifists. He was an arrogant theorist who truly believed in the magical elixir of large government and in the technocratic dream of controlling billions of personal, business and economic decisions, to programmatically construct a perfect world order. Keynes gave intellect and jargon filled cover and rationale to politicians and demagogues who would cite his book, 'The General Theory of Employment, Interest and Money', to justify state interventionism.

According to this theory which has failed in practice every time it has been tried, governments can stimulate an economy through granting consumers, workers and businesses sums of borrowed money. This is termed a 'stimulus'. This debt or current deficit financing stimulus, is then paid back or retired, when the economy strengthened by consumer spending and business investment, produces a surplus of tax revenues. The stimulus is needed, so argued Keynes, to overcome business cycles, downturns and unexpected events which would decrease jobs, increase unemployment and impact state revenues. By macro and micro-managing economic and production processes, the state, so thought Keynes, would avoid cyclical variations and ensure that the lowest level of unemployment could be maintained. Government power was thus indispensable to full employment and income equality.

The Political Failure of Keynesian Economics

Last August I asked a question: "What if Keynesian stimulus works, but no one can ever actually afford to do it, short of something like World War II, where the government can tap into a patriotic outpouring of national savings by issuing bonds with negative real yields."

When people like Paul Krugman say that almost $900 billion in stimulus didn't work because it wasn't big enough, you have to wonder if an adequate Keynesian stimulus is even possible. Could any government anywhere borrow 15% of GDP or more to spend on temporary measures with the blessing of their citizens? For that matter, would the markets lend the money without ratcheting up interest rates? Can an extra 15% of GDP be spent without showing sharply diminishing returns--meaning that you'd need even more spending to generate the effects you want?

Today Alex Tabarrok looks at the history and concludes that even if Keynesian economics works in theory, Keynesian politics fails in practice--at least in a Democracy:

Ron Paul called the housing bubble and subsequent recession in 2003 during a banking committee session. No one listened to him. That's not hilarious, it is sad. Here it is....

Ron Paul in the House Financial Services Committee, September 10, 2003

Mr. Chairman, thank you for holding this hearing on the Treasury Department's views regarding government sponsored enterprises (GSEs). I would also like to thank Secretaries Snow and Martinez for taking time out of their busy schedules to appear before the committee.

I hope this committee spends some time examining the special privileges provided to GSEs by the federal government. According to the Congressional Budget Office, the housing-related GSEs received $13.6 billion worth of indirect federal subsidies in fiscal year 2000 alone. Today, I will introduce the Free Housing Market Enhancement Act, which removes government subsidies from the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the National Home Loan Bank Board.

One of the major government privileges granted to GSEs is a line of credit with the United States Treasury. According to some estimates, the line of credit may be worth over $2 billion. This explicit promise by the Treasury to bail out GSEs in times of economic difficulty helps the GSEs attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital. More importantly, the line of credit is a promise on behalf of the government to engage in a huge unconstitutional and immoral income transfer from working Americans to holders of GSE debt.

The Free Housing Market Enhancement Act also repeals the explicit grant of legal authority given to the Federal Reserve to purchase GSE debt. GSEs are the only institutions besides the United States Treasury granted explicit statutory authority to monetize their debt through the Federal Reserve. This provision gives the GSEs a source of liquidity unavailable to their competitors.

The connection between the GSEs and the government helps isolate the GSE management from market discipline. This isolation from market discipline is the root cause of the recent reports of mismanagement occurring at Fannie and Freddie. After all, if Fannie and Freddie were not underwritten by the federal government, investors would demand Fannie and Freddie provide assurance that they follow accepted management and accounting practices.

Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.

No less an authority than Federal Reserve Chairman Alan Greenspan has expressed concern that government subsidies provided to GSEs make investors underestimate the risk of investing in Fannie Mae and Freddie Mac.

Mr. Chairman, I would like to once again thank the Financial Services Committee for holding this hearing. I would also like to thank Secretaries Snow and Martinez for their presence here today. I hope today's hearing sheds light on how special privileges granted to GSEs distort the housing market and endanger American taxpayers. Congress should act to remove taxpayer support from the housing GSEs before the bubble bursts and taxpayers are once again forced to bail out investors who were misled by foolish government interference in the market. I therefore hope this committee will soon stand up for American taxpayers and investors by acting on my Free Housing Market Enhancement Act.

Those patiently following the Greek Bond-Bund spread to its inevitable conclusion have been fully aware that the plan that Europe is betting its entire future on, is patently flawed: namely that austerity, by its definition does not, and will not work. In fact, instead of bringing stability, austerity will slowly but surely eat away at the economy of whatever country it is instituted in - in some cases slowly, in others, like Greece, very rapidly. Indeed, the Greek spread has now risen to levels last seen during the early May near-revolution in Athens, at well over 800 bps. And for the specific consequences of austerity, Germany's Spiegel has done a terrific summary of what it defines as a "death spiral" for the Mediterranean country: "Stores are closing, tax revenues are falling and unemployment has hit an unbelievable 70 percent in some places. Frustrated workers are threatening to strike back. A mixture of fear, hopelessness and anger is brewing in Greek society." Spiegel quotes a atypical Greek: ""If you take away my family's bread, I'll take you down -- the government needs to know that. And don't call us anarchists if that happens! We're heads of our families and we're desperate." All those who think violent strikes in the PIIGS are a thing of the past, we have news for you. The (pseudo) vacation season is over, and millions of workers are coming back. They may not have money, but they have lots of free time, lots of unemployment, and even more pent up anger. Things are about to get very heated once again, first in Greece, and soon after, everywhere else.